UniversityofTexasatDallas

SchoolofManagement
Finance6301
CorporateFinance

ProfessorDay
Fall1999
Lecture7:ExchangeRatesandInvestmentDecisions

TheForeignExchangeMarket
The market for foreign exchange is the world's largest financial market. Trading is
conducted through an overthecounter network of traders from major commercial and
investmentbankslinkedbyphone,computerterminalandothertelecommunicationsdevices.
MajortradingcentersincludeLondon,NewYorkandTokyo,withtotaltradingvolumeinexcess
of$1.25trilliondollars offoreigncurrencyperday. Morethanhalfofalltradingdirectly
involvestheexchangeofdollars.Participantsincludeimportersandexporters,aswellastraders,
portfoliomanagersandforeignexchangebrokers. Theimportanceoftradingothercurrencies
againstU.S.dollarsarisesfromthefactthatcurrencydealersquoteothercurrenciesagainstthe
dollarwhentradingamongthemselves.
MethodofQuotation
Thearetwomethodsofquotationforexchangeratesbetweenthedollarandthecurrencyof
another country. The two methods are referred to as the direct (American) and indirect
(European)methodsofquotation.Theexchangeratebetweenanytwonondollarcurrenciesis
referredtoasacrossrate
1.

Direct/AmericanQuotation
Thedollarpriceofoneunitofforeigncurrency. Forexample,adirectquotationofthe
exchange rate between dollar and the British pound (German mark) is $1.6000/1
($0.6000/DM1), indicating that the dollar cost of one British pound (German mark) is
$1.6000($0.6000).Directexchangeratequotationsaremostfrequentlyusedbybanksin
dealingwiththeirnonbankcustomers.Inaddition,thepricesofcurrencyfuturescontracts
tradedontheChicagoMercantileExchangearequotedusingthedirectmethod.

2.

Indirect/EuropeanQuotation
Thenumberofunitsofaforeigncurrencythatarerequiredtopurchaseonedollar. For
example,anindirectquotationoftheexchangeratebetweenthedollarandtheJapaneseyen
(Germanmark)is125.00/$1(DM1.6667/$1),indicatingthatonedollarcanbepurchased
foreither125.00JapaneseYenor1.6667GermanMarks.

3.

CrossRates

Theexchangeratebetweenanytwonondollarcurrenciesisreferredtoasacrossrate.A
relativelylargenumberofcrossrateswouldberequiredtotradeeverycurrencydirectly
againsteveryothercurrency.Forexample,NcurrencieswouldrequireNx(N1)/2separate
crossrates.Forthisreason,mostexchangeratesarequotedintermsofdollarsandbyfar
thegreatestvolumeoftradingdirectlyinvolvesthedollar. Thisreducesthenumberof
crosscurrency quotes that dealers must keep track of and reduces the potential losses
associated with mispricing currencies relative to one another (which permits Triangular
Arbitrage).

TheRelationbetweenDirectandIndirectExchangeRateQuotations
An indirect exchange rate quotation is simply the reciprocal of the direct exchange rate
quotation.Inotherwords
S=.
wherethesuperscriptsareactuallyunnecessaryinthatwewillusethenotationF/$todenotean
indirectquotationintermsofunitsofcurrencyFrequiredtopurchaseonedollar.Similarly,we
willusethenotation$/Ftodenoteadirectquotationintermsofthenumberofdollarsrequiredto
purchaseoneunitofcurrencyF.Toillustratethisprincipal,supposethatthedirectquotationfor
theexchangeratebetweenthedollarandtheGermanmarkis$0.6000/DM1.Thentheindirect
quotationfortheexchangeratebetweenthedollarandthemarkwouldbe
S

=,
=DM1.6667/$1.

CurrencyMarkets
Foreign exchange transactions that are settled immediately are said to occur in the spot
market,whiletransactionstobesettledatafuturedateoccurineithertheforwardorthefutures
market.Thesemarketsaresummarizedbelow:
1.

SpotMarket
Themarketforcurrencyforimmediatedelivery.Thepriceofforeignexchangeinthespot
marketisreferredtoasthespotexchangerateorsimplythespotrate.

2.

ForwardMarket
Themarketfortheexchangeofforeigncurrenciesatafuturedate. Aforwardcontract
usuallyrepresentsacontractbetweenalargemoneycenterbankandawellknown(tothe
bank)customerhavingawelldefinedneedtohedgeexposuretofluctuationsinexchange
rates.Althoughforwardcontractsusuallycallfortheexchangetooccurineither30,90or
180days,thecontractcanbecustomizedtocallfortheexchangeofanydesiredquantityof
currencyatanyfuturedateacceptabletobothpartiestothecontract.Thepriceofforeign
currencyforfuturedeliveryistypicallyreferredtoasaforwardexchangerateorsimplya
forwardrate.

3.

FuturesMarket
Although the futures market trading is similar to forward market trading in that all
transactionsaretobesettledatafuturedate,futuresmarketsareactualphysicallocations
whereanonymousparticipantstradestandardquantitiesofforeigncurrency(e.g.,125,000

DMpercontract)fordeliveryatstandardfuturedates(e.g.,March,June,September,and
December).
The most active forward markets are those forthe Japanese yen and the German mark.
ActivemarketsalsoexistfortheBritishpound,theCanadiandollarandthemajorcontinental
currencies,theSwissfranc,theFrenchfranc,theBelgianfranc,theItalianLiraandtheDutch
guilder. Forward markets for currencies of less developed countries are either limited or
nonexistent.TheChicagoMercantileExchangetradesfuturescontractsonyen,marks,Canadian
dollars,Britishpounds,Swissfrancs,Australiandollars,Mexicanpeso'sandeuros.

TriangularArbitrage
GiventheexchangeratebetweenthedollarandtheBritishPound,S $/,andtheexchange
ratebetweenthedollarandtheGermanMark,S $/DM ,theexchangeratebetweentheGerman
MarkandtheBritishPound,SDM/,shouldbe
SDM/

=.

Forexample,iftheexchangeratebetweenthedollarandtheBritishPoundis$1.50/1andthe
exchangeratebetweenthedollarandtheGermanMarkis$.75/DM1,theexchangeratebetween
theGermanMarkandtheBritishPoundis
SDM/

=,
=DM2/1.

IftheexchangeratebetweentheGermanMarkandtheBritishPoundwereeithergreaterorless
thanDM2/1,thenatriangulararbitrageopportunitywillbeavailable. Forexample,suppose
thattheMark/PoundexchangeratewereDM2.1/1. ThenatraderwithtwoGermanMarks
would(1)exchangethemfor$1.50(2x$.75/DM1).The$1.5wouldthen(2)beexchangedfor
oneBritishPound,whichwouldthen(3)beusedtopurchaseDM2.1,whichisgreaterthanthe
numberofGermanMarksthatthetraderstartedwith.
InterestRateParity
TheInterestRateParityTheoremsaysthattherelationbetween(a)foreignanddomestic
interestratesand(b)theforwardandspotexchangeratesisgivenby
=,
whereF$/Fdenotesthe(direct)forwardexchangeratebetweenthedollarandanarbitraryforeign
currencyF,S$/F denotes thespotrate,withRUS andRF respectivelydenotingtheU.S.and
foreigninterestrates.TheInterestRateParityTheoremimpliesthatthecurrencywiththehigher
interestratewillalwaysbeataforwardpremiumtothecurrencyhavingthelowerinterestrate.
Inotherwords,theforwardexchangeratewillbegreater(less)thanthespotratewheneverthe
U.S.interestrateisgreater(less)thantheforeigninterestrate.
Sincethedirectandindirectexchangeratequotationsarereciprocalsofoneanother,the
interestrateparitycanalsobeexpressedintermsoftheindirectquotationsforthespotand
forwardexchangerates,
=.

AnviolationofInterestRateParitywouldallowinvestorsineithertheU.S.orthe
countrydenotedbyFtoearnmorethantheirdomesticriskfreerateofinterest(i.e.,RFforaU.S.
investor).Forexample,aviolationofinterestrateparitymaypermitaU.S.investorto
simultaneously(1)convertdollarstoforeigncurrencyatthespotrate,(2)investinriskfree
foreignsecuritiesatarateofRF,and(3)hedgethefuturevalueoftheinvestmentagainst

fluctuationsintheexchangeratebysellingtheforeigncurrencytobereceivedintheforward
market.Thus,theInterestRateParityTheoremessentiallystatesthatnninvestormustearn
thesamerateofreturnbyinvestinginriskfreemoneymarketsecuritiesathome(e.g.,the
U.S.)ascouldbeearnedfromahedgedinvestmentinriskfreeforeignmoneymarket
securities.
Toexploretheimplicationsofinterestrateparityfurther,considerthefactthataninvestor
whowishestoinvest$1inriskfreesecuritieshastwoalternatives.
1. Byinvestingathomeindollardenominatedmoneymarketsecurities,aninvestor
earnsinterestatarateofRFperperiod.Thus,attheendofoneperiodtheinvestor
receives

$1x(1+RUS).
2. Alternatively,iftheinvestorinvestsonedollarinforeignbonds,thentheinvestor
must
a. Convertonedollartounitsofforeigncurrency,
b. Invest in foreign securities at an interest rate of R F, giving units of foreign
currencyatmaturity,
c. Eliminateanyexchangerateriskbysellingthecurrencytobereceivedinthe
forwardmarketatthecurrentforwardrateofF$/Fgivingfuturedollarproceedsof
F$/F.
Thesearchbyinvestorsforthehighestpossibleriskfreereturnsimpliesthatpricesmust
adjustsothatthereturnfrominvestingindollarsisequaltothehedgedreturnfrominvestingin
theforeignmoneymarketsecurities.Inotherwords,
$1x(1+RUS)=F$/F,
whichimpliesthat(1+RUS)/(1+RF)mustequaltoF$/F/S$/F.

Example:
SupposethatyoucaninvestinU.S.GovernmentTreasurybillforoneyearataninterestrate
of5percent.ThespotexchangeratebetweendollarsandFrenchfrancs(S $/F)is$0.2000/FF1,
whiletheforwardexchangerate(F$/F)is$0.2020/FF1.Assumingthatyouareabletoinvestin
riskfreeFrenchbondsforoneyearataninterestrateof4.25percent,thereturnsfrominvesting
indomesticandforeignbondsarerespectivelyequalto
1. DomesticInvestment
$1x(1+RUS)

=$1x1.05
=$1.05.

2. ForeignInvestment
F$/F

=x1.0425x$0.2020/FF1
=$1.0529.

Inotherwords,wecanearn5.0percentbyinvestingintheU.S..However,wecouldearn
5.29percentbyconvertingdollarstoFrancs,investingat4.25percent,andpurchasingforward
coverbysellingtheFrenchfrancstobereceivedoneyearfromnowintheforwardmarketfor
$0.2020/FF1.

CreatingaMoneyMarketHedge
TheInterestRateParityrelationcanberearrangedtoshowthat
F$/F

=S$/F.

Theexpressionaboveshowsthatthepresentvalueoftheproceeds fromselling(orcostof
buying)currencyfordollarsintheforwardmarketshownonthelefthandsideaboveshould
equalthecurrentdollarvalue(atthespotexchangerate)ofthepresentvalue(discountedatthe
foreigninterestrate)oftheamounttobereceivedorpaidthatisshownontherighthandside.
Therefore,InterestRateParityimpliesthattherearetwoalternativemechanismsforhedging
exchangeraterisksuchasaccountsreceivableandaccountspayable.
HedginganAccountReceivable
The most simple procedure for hedging an account receivable is to simply to sell the
receivableintheforwardmarketatapriceofF $/F perunitofforeigncurrency. Thepresent
valueofthisstrategyissimplythelefthandsideoftheexpressionabove
F$/F.
Alternatively,wecouldborrowanamountequaltothepresentvalue(discountedattheinterest
rateintheforeigncountry)oftheaccountreceivable,.Thecurrentdollarvalueoftheproceeds
oftheloanisrepresentedbytherighthandoftheaboveexpression,
S$/F.
Whentheloancomesdue,theliabilitycanberepaidusingtheproceedsfromcollectionofthe
accountreceivable.
HedginganAccountPayable
Similarly, can hedge an account payable by entering into a forward contract to buy the
foreigncurrencyatapriceofF$/Fperunitofforeigncurrency.Thepresentvalueofthisstrategy
is
F$/F.
Alternatively,sincethepresentvalue(discountedattheforeigninterestrate)ofaliabilityofone
unitofforeigncurrencyis1/(1+RF),wecaneliminateanyexchangerateriskassociatedwiththe
futureliabilitybyimmediatelyconverting
S$/F
dollarstounitsofforeigncurrencyandinvestingattheforeigninterestrateofR F .Whenthe
liabilitycomesdue,thisnumberofpresentdollarsisguaranteedtobeequalto1unitofforeign
currency,whichcanthenbeusedtopaytheforeigncurrencydenominatedpayable.
8

Example:(HedginganAccountReceivable)
AssumethatyourfirmhasanaccountreceivableofonemillionSwissfrancsthatisduetobe
received in 180 days. The spot exchange rate (S$/F ) is $0.8800/SF1 , while the forward
exchangerate(F$/F)fordeliveryin180daysis$0.8950/SF1.TheinterestrateintheU.S.fora
180dayperiod(RUS )is2.6percentwhiletheSwissrateofinterest(R F )for180daysis1
percent.
Thepresentvalueofsellingthefrancsintheforwardmarketis
F$/FSF1,000,000

=$0.8950/SF1SF1,000,000,
=$872,319.69.

Thepresentvaluefromborrowingthepresentvalueofthereceivable(denominatedinunitsof
foreigncurrency)andconvertingtodollarsis
S$/FSF1,000,000

=$0.8800SF1,000,000.
=$871,287.13.

Sincethepresentvalueofsellingthecurrencyintheforwardmarketis$872,319.69whilethe
presentvalueofthemoneymarkethedgeis$871,287.13,itwouldbebettertohedgebyselling
thecurrencyforward.
IfweneededtohedgeanaccountpayableofSF1,000,000duein180days,theamounts
abovewouldrepresentthepresentvalueofthecostofhedging.Inthiscase,wewouldgowitha
moneymarkethedge,sincethepresentvalueofthemoneymarkethedge($871,287.13)isless
thanthecostofhedgingintheforwardmarket.

TheExpectationsTheoryAppliedtoExchangeRates
The Expectations theory argues that the forward rates quoted in the market for foreign
exchangeareusefulinforecastingfutureexchangerates.Inparticular,theExpectationstheory
arguesthatforwardratesareexactlyequaltothespotexchangeratethatisexpectedonthe
deliverydatespecifiedintheforwardcontract(30,60,90or180daysinthefuture).Thus,the
Expectations theory implies that theforwardexchangerates quotedin theforeign exchange
marketareunbiasedforecastsoftheexchangeratestheareexpectedinthefuture. Whilethe
exact economic circumstances under which the Expectations theory holds are complex to
describe,empiricalevidencesuggeststhattheExpectationstheoryisafairlygooddescriptionof
thetruerelationbetweenforwardexchangeratesandexpectedfutureexchangerates.
The Expectations theory implies that the cost of hedging exchange rate risk is costless.
Considerthefollowingalternativesforhedgingexchangeraterisk:
1.

Alwaysinvoiceindollars
Although invoicing in dollars completely avoids losses (and gains) attributable to
fluctuationsofthevalueofforeigncurrencyrelativetothedollar,arefusaltoinvoicein
aforeigncustomer'sowncurrencymayresultinalossofsalestocompetitorswillingto
invoiceinthethecustomer'sowncurrency.

2.

Sellingforeigncurrencyforward
Thisalternativeisdesirabletotheextentthatexchangerateriskiseliminated.However,
sellinganticipatedreceivablesdenominatedinforeigncurrenciesintheforwardmarket
iscostlywhenevertheforwardratedifferssystematicallyfromthespotexchangerate
thatisexpectedtoprevailwhenthereceivableisscheduledtobecollected.Therefore,
thecostoftheinsuranceobtainedbysellingcurrencyintheforwardmarketisthe
difference between the forward rate, F, and the expected spot rate, E(S). If the
expectationstheoryholds(i.e.,forwardratesarealwaysequaltotheexpectedspotrate),
thenthecostofhedging(insuringagainst)theriskoffluctuationsinexchangeratesis
zero. Inpractice,differencesbetweenforwardrates andactualfuturespotratesare
smallonaverage.

10

AbsolutePurchasingPowerParity(TheLawofOnePrice)
The exchange rate between any pair of currencies is roughly equal to the ratio of the
domesticandforeignpricesofanygoodthatmaybefreelytraded(tradedgoods)betweenthe
twocountrieswithminor(perunit)shippingcosts.Inotherwords,thepriceofagoodindollars
shouldbeequalthepriceofthatgoodinBritishpoundsafterthepriceinBritishpoundshasbeen
convertedtoadollarpriceusingtheprevailingexchangeratebetweenthedollarandtheBritish
pound.Formally,
P=S$/P,
whichimpliesthat
S$/=.
Forexample,ifthepriceofonetonofsoybeanmealinChicagois$225andthepriceofone
tonofsoybeanmealinLondonis150,thentheexchangeratebetweenthedollarandtheBritish
poundshouldbe
S$/

=,
=$1.50/1.

11

TheHamburgerStandard(TheEconomistofApril15,1989)
Country

BigMacPricein
LocalCurrency

BigMac
ExchangeRate

Actual
ExchangeRate

France

FF17.70

$0.114/FF1

$0.157/FF1

Germany

DM4.30

$0.469/DM1

$0.529/DM1

$1.610/1

$1.690/1

183/$1

133/$1

Britain

1.26

US

$2.02

Japan

370

NotethatyougetmoreYenforyourdollarifyoutradeBigMacsforyenrathertheDollarsfor
Yen.IfwecouldinfacttransportBigMacsfromJapan,thenwecouldearnanarbitrageprofit
by
1. BuyoneBigMacintheU.S.for$2.02,
2. SelloneBigMacinTokyofor370(i.e.,[183/$1]x$2.02)
3. ConverttheYentoDollarsat133/$1whichimpliesthatyouendupwith
$2.78=370
ThearbitragemechanismrequiredforPurchasingPowerParityistoholddependson
1. Lowperunitcostoftradingandshippingcommoditiesfromonecountrytoanother,
2. Absenceofbarrierstotradesuchastaxesandtariffs,
3. Standarddefinitionofthegoodsinquestion.
TheconditionswhichpermitPurchasingPowerParitytoholdgiverisetothedistinction
between
1. TradedGoods(e.g.,crudeoil,wheat,andsoybeanmeal)
2. NonTradedGoods(e.g.,haircuts)

12

RelativePurchasingPowerParity
The Relative version of the Purchasing Power Parity theorem states that changes in the
exchangeratebetweentwocurrenciesaredeterminedbychangesintherelativepricesinthetwo
countriesinquestion.Inotherwords,
=.
IfwelettheratioP/Prepresenttheexpectedrateofinflation,I $,thentheexpectedexchangerate
canbeexpressedas

E(S)=S.

For example, assume that the exchange rate between the dollar and the French franc is
currently$0.1600/FF1. ThenifinflationintheU.S.isexpectedtobe3percentperyearand
inflationinFranceisexpectedtobe5percentperyear,theexchangeratebetweenthedollarand
theFrenchfrancinoneyearshouldbe
$0.1570/FF1=$0.1600/FF1.
TheRelativePurchasingPowerParityrelationcanbegeneralizedtopredictexchangeratesN
periodsinthefuture(assumingofcoursethatwehaveforecastsofinflationintherespective
countriesoverthetimeperiodcoveredbytheexchangerateinquestion).Thisgeneralrelationis
givenby

E(S)=S[]

Forexample,assumingthatinflationintheU.S.andFrancearerespectivelyexpectedtorunat3
percentand5percentperyearoverthenexttwoyears,theexchangeratebetweenthedollarand
theFrenchFrancintwoyearsshouldbe
$0.1540/FF1=$0.1600/FF1.
Intuitively,ifacountryexperienceshigherinflationthanitstradingpartners,thenitsexports
becomelesscompetitiveoverseasandforeignimportsbecomemorecompetitiveathome.The
resultingdeficitinthebalanceoftradeputsdownwardpressureontheexchangerate.

13

TheInternationalVersionoftheFisherEquation
TheFisherEquation(namedafterIrvingFisher)expressesthenominalordollardenominated
rate of interest in terms of the expected rate of inflation and the real or purchasing power
denominatedrateofinterest.AlthoughtheFisherEquationisnotaprecisetheoryoftherelation
betweeninterestratesandtheexpectedrateofinflation,itisafairlycloseapproximation.Ifwe
denotetherealrateofinterestbyandtheexpectedrateofinflationbyI,theFisherEquationis
givenby
1+R=(1+)(1+I)
Forexample,iftherealrateofinterestis0.0125(1.25percent)andtheexpectedrateof
inflationis4percent,thenthenominal(dollardenominated)rateofinterestwillbethesolution
to
1+R

=(1+.0125)(1+.04)

whichimpliesthat
R

=1.0125x1.041
=5.30percent(.0530)

AninternationalversionoftheFishereffectisoftenusedtospecifyhowdifferencesinthe
respectiveratesofinflationacrosscountriesdeterminethedifferencesininterestratesacross
countries.IfweassumethattheFisherEquationholdssimultaneouslyinboththeU.S.andin
countryFR,thenwehave
=.
Ifcapitalflowsfreelyfromonecountrytoanother,chasingthehighestinterestrates,then
therewillbeatendencyforrealratestobeequalizedacrosscountries.Ifthisisthecase,thenthe
U.S.andcontryFshouldhavethesamerealrateofinterest(i.e.,USequalsF).Therefore,
=.
Theexpressionaboveimpliesthatallwehavetodotoinferthedifferenceintheexpected
ratesofinflationintwocountriesistoobserverthedifferenceinthenominalinterestratesin
thosetwocountries. Forexample,supposethatthenominalrateofinterestintheU.S.is6
percentandthatthenominalrateofinterestinJapanis2.5percent.Thenassumingthatthereal
rateofinterestintheU.S.isequaltotherealrateofinterestinJapan,thedifferencebetweenthe
expectedratesofinflationintheU.S.andJapanis
=,
=1.034,
14

indicatingthatinflationintheU.S.isapproximately3.4percentgreaterintheU.S.thaninJapan.

15

InordertoforecastfutureexchangeratesusingRelativePurchasingPowerParity,we
needagoodforecastinthedifferenceintheexpectedratesofinflationinthetwocountriesin
question,
N

E(S)=S[] .
Forecastingtheinflationrateisalwaysverydifficult.However,ifwearesatisfiedthatthe
realinterestratesintwocountriesareapproximatelyequal,thentheFisherEquationallowsusto
approximatedifferencesinexpectedinflationratesusingthedifferenceinthenominalinterest
rates.Therefore,wecanforecastexchangeratesusingthenominalratesofinterest,
N

E(S)=S[] .
For example, suppose that the exchange rate between the dollar and the Swiss franc is
$0.6500/SF1.Further,theU.S.interestrateis5.3percentperyearandtheSwissinterestrateis
2.5percentperyear.Ourforecastoftheexpectedexchangerateinoneyearwouldbe
E(S)

=$0.6500/SF1x[] ,
=$0.6678/SF1.

Similarly,theappropriateforecastfortheexchangeratebetweenthedollarandtheSwiss
francin2yearswouldbe
E(S)

=$0.6500/SF1x[] ,
=$0.6860/SF1.

16

ValuingDirectForeignInvestments
Thelogicunderlyingthevaluationofacapitalinvestmentprojectthatgeneratefuturecash
flows denominated in a foreign currency is similar to that underlying a standard capital
budgetingproblem.Thatis,weshouldidentifytheincrementalcashflowsanddiscountthemat
theappropriateweightedaveragecostofcapital.Foreigninvestmentdecisionsarecomplicated
by
a.conversionofforeignexchangetodollars,
b.restrictionsontherepatriationofcashflows.
While accounting for the potential impact of unanticipated future restrictions on the
repatriationoffuturecashflowsisparticularlydifficult,convertingastreamoffuturecashflows
denominated in a foreign currency to a projected dollar denominated stream is relatively
straightforward.Thenetpresentvalueoftheprojectedfuturecashflowscanthenbedetermined
usingthefirm'sdollardenominatedweightedaveragecostofcapital. Wecansummarizethis
approachtothevaluationofinvestmentsinforeigncountriesasfollows:
a.estimatefutureforeigncurrencydenominatedcashflow,
b.convertforeigncurrencytodollarsattheprojectedexchangerate,
c.determinethenetpresentvalueusingthedomestic(U.S.)costofcapital.
Example:ValuationofForeignInvestments
Considerthefollowingexample.BecauseofarecentbanontheimportofU.S.madetennis
racketstoGermany(inretaliationforanticipatedrestrictionsontheimportofGermanmade
goodstotheU.S.),aU.S.sportinggoodsmanufacturerexpectstocreateaGermansubsidiaryto
manufactureanddistributetennisracketsinGermany.
Theprojectlifeisexpectedtobetwoyears(atwhichtime,anendtoprotectionistsentiment
intheU.S.willleadtoanendtotraderestrictions).Therequiredinvestmentintheprojectis
a.DM25,000,000inplantandequipment,
b.DM5,000,000inworkingcapital.
TheprojectedaftertaxcashflowsfromtheprojectareDM20,000,000forthenexttwo
years,inadditiontoDM5,000,000fromtheliquidationofworkingcapitalintwoyears.Thespot
exchangerate(S$/DM)is$0.6500/DM1.TheinterestrateintheU.S.(R US)is6percentperyear
whiletheGermaninterestrate(RDM)11percentperyear.

17

PredictedExchangeRates
Iftherealrateofinterestisthesameinallcountries(duetotheinternationalmobilityof
capital)the International Fisher Effect implies thatdifferences innominal interest rates will
signaldifferencesintheexpectedratesofinflationacrosscountries.GiventhatR USis6percent
peryearandthattheGermaninterestrateRDM is11percentperyear,wewouldexpectthe
expectedrateofinflationinGermanytoberoughly5percentgreaterthantheexpectedrateof
inflationintheU.S..
RelativePurchasingPowerParityimpliesthattheexpectedchangesinexchangeratesshould
reflectdifferencestheexpectedratesofinflationinthetwocountriesinquestion,

=[]

whereE(S$/DM(t+n) )denotestheexchangerateexpectedinnperiods. Thisformulaimplies

thatoverthenexttwoyearswecanexpectthefollowingexchangerates
E(S$/DM(t+1))=$0.65/DM1[],
=$0.6207/DM1,
and
E(S$/DM(t+2))=$0.65/DM1[],
=$0.5928/DM1.
The anticipated structure of exchange rates can be used to convert the anticipated WV
denominatedcashflowstodollars,whichcanthenbediscountedusingtheUScostofcapital.
0

CashFlowsin1000sofDM
1

InvestmentinDM
a.PlantandEquipment

<DM25,000>

b.WorkingCapital

<DM5,000>

DMCashFlows

DM5,000
DM20,000
DM20,000

TotalDMCashFlows

<DM30,000>

DM20,000

ProjectedExchangeRate

$0.6500/DM1

$0.6207/DM1 $0.5928/DM

18

DM25,000

ProjectedDollarCashFlow

<$19,500>

$12,414

$14,820

Assumingthatthefirmhasaweightedaveragecostofcapitalof12percent,thenetpresent
valueoftheprojecteddollarstreamofcashflowsis$3,398(1000s),whichindicatesthatthe
projectshouldbeaccepted.

19